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Earnings Call Transcript 2019-Q1

[Jakob O. Sigurdsson, CEO & Executive Director]

[Audio Gap] '19 financial year, and we have signaled that in December as we expected a tough first half and a tough first quarter particularly. This outlook, as it turned out to be slightly weaker than we anticipated, but principally reflects the expected end-market headwinds and some destocking in our supply chains as well.Q1 headwinds were largely in the Automotive and Consumer Electronics market. And if we take Automotive first, we did see a number of OEMs and suppliers talk about the WLTP issues and the destocking within auto as well as a drop in demand both in Europe and China. This volume impact doesn't just come in our Auto segment. Remember that we also see some impact of that in our Value Added Resellers segment, too, where our customers in that channel have some of them quite significant exposure to the Automotive market.So a tough shortened picture in Auto, although both January and February are showing some initial improvements. And the PEEK penetration story in itself in Auto is unchanged on a medium-term basis. As you also know that IHS still forecasted growth in car build for 2019 overall of around 1% versus the final figure of 2018 being actually a decline of 1%, and in fact, a much worse decline in the final calendar quarter of 2018, which is our quarter 1. On the Consumer Electronics side, and this sort of specifically refers to the large Consumer Electronics contract, we did not supply any volumes to that contract in the first quarter. Whereas last quarter, we -- last financial year, first quarter, we supplied in excess of 100 tonnes. In our other markets, we did see growth in Energy and Medical. It was ahead in constant currency. This continues to be a stable trend that we saw in the second half of 2018. For further details and color on the numbers, I'll hand it over to Richard now.

[Richard Armitage, Group Finance Director & Executive Director]

Thank you, Jakob. So building on Jakob's comments, we said at our full year results in December that Automotive volumes were down over 20% in our first 2 months of trading. And December turned out to be a particularly weak month. Automotive in the end was 23% down year-on-year in the first quarter, and that very much mirrors what we see happening in the wider market.In relation to the large Consumer Electronics contract, we have signaled for some time that we expected that this contract would wind down to 0 this year. This has happened. Whereas in quarter 1 of last year, we have seen 110 tonnes of supply.We then saw some declines in Value Added Resellers, mostly linked to Auto or Electronics. And we saw quite considerable destocking ahead of our customers' year-ends. This explains the balance of the 230 tonne decline in quarter 1 on quarter 1. In summary then, quarter 1 revenue of GBP 64.1 million was 18% down on the prior year, with quarter 1 group sales volume of 822 tonnes being 22% down on the prior year. At constant currency, revenue was 14% down. If we exclude the volumes for the large Consumer Electronics contract, core business volumes were down approximately 13%. Also impacting us in quarter 1 is currency. We signaled a GBP 6 million to GBP 8 million of currency and inflation headwind for the full year, our PBT level, with that all falling in the first half and a large proportion of it in quarter 1. This high cost of manufacture will impact first half gross margin. Although as an ASP level, as you can see, we were slightly ahead of last year at GBP 78 per kilo.This reduced the mix where we've seen solid performance in Medical, and we benefit from the absence of large Consumer Electronics volumes. It's worth considering that based on an improvement in Industrial for the second half, we would expect full year ASP to reduce from the quarter 1 level, but it's still to be slightly ahead of the GBP 74 per kilo we saw in FY '18. Finally, the consensus of external expectations is for our profit to decline on a full year basis to around GBP 124 million to GBP 125 million currently. This assumes a weaker-than-anticipated first half and a better second half, albeit not enough to offset the first half weakness. For the second half, we do expect an improvement in our market environment, particularly in Automotive, the benefit of new projects and reduced headwinds that should return us to growth. We will be helped by an improving gross margin as currency and inflation headwinds work their way through. And we will also be helped by a bonus accrual that will be GBP 5 million lower year-on-year in the second half. Remember that our all-employee bonus scheme only pays out on PBT growth. Thank you. And I'll now hand back to Jakob, who will cover our investments announced this morning.

[Jakob O. Sigurdsson, CEO & Executive Director]

So thank you, Richard. Four main highlights to touch on briefly around the mega programs and new investments. On Gears, we have passed an advanced prototyping stage with a major global car manufacturer ahead of a second and larger supply agreement for PEEK-based Gears. This is expected to start in the second half and also builds on 2 smaller supply agreements now in place. So we're focused on execution in the area of Gears, and we would expect Gears to reap meaningful revenue for the year. In Medical, our partner in Knee, Maxx Orthopedics, is now ready to start patient recruitment. This will drive a clinical trial over the next 18 months, a significant milestone for us in the Medical space.This morning, we also announced 2 small investments in enabling technologies to make markets for PEEK. First, a small equity stake in a U.K.-based company called Surface Generation, which has a state-of-the-art manufacturing process, which will support our mega programs and how we can manufacture more complex parts out of PEEK.Secondly, 3D printing has always been an area of great interest for us. And to enact that and progress our transition into 3D printing, we're investing in a minority equity position with Bond 3D High Performance Technology, which is a Dutch company developing unique, protectable 3D printing processes. Again, this is aligned to support our ability to make parts, and we think this will help us tremendously in the Medical market particularly. Turning a little bit to the outlook. On our outlook, I said that Q1 was slightly weaker than we had expected, but we have seen some initial improvements in January, and January indeed turned out to be our second largest in history. Order book for February also looks solid at this stage, although the first half overall is expected to be weaker, as alluded to and talked about in our first -- in our full year earnings release in December.Our expectations for the second half are unchanged with new projects and improving industrial performance and reduced headwinds supporting our assumptions, to that effect. As we note in our statement, on a medium- to long-term view, we have a strong structural growth opportunity, a healthy product pipeline and a highly cash-generative business model. We, therefore, continue to be well-placed for the medium and long term. Thank you. And I'll now hand it over to Q&A.

[Operator]

[Operator Instructions] And our first question comes from the line of Thomas Wrigglesworth of Citi.

[Thomas P Wrigglesworth]

Just a couple of questions. Firstly, looking at that -- at the second half specifically with regards to the Gears and the new products coming through, should we expect positive mix effect from these new products? Or are they going to be -- will they be slightly dilutive as you ramp up in early phase? How should we think about the margin mix? And then secondly, just on -- just to -- if you can help me try and calibrate your comments on January and February. So is January good enough that it's effectively recouped all of the fourth quarter headwinds that we've seen -- sorry, first quarter headwinds that we've seen? And how should we think about that softness in the first half? Are we talking single-digit softness? Those are my 2 questions.

[Richard Armitage, Group Finance Director & Executive Director]

Tom, it's Richard. So firstly, on Gears, we can expect a very slight dilutive effect on the gross margin percent. So the way to think about this is, first of all, the new opportunity allows us to sell model PEEK and our traditional margins and thereby generating good cash from the opportunity. But then the manufacturing of gross margin of the actual gear on top of that is likely to be in the mid-40s kind of range rather than mid-60s. So that will have a slight dilutive effect on the reported gross margin percent.

[Jakob O. Sigurdsson, CEO & Executive Director]

And even with a strong January and a good order book in February, it will not be sufficient enough to cover up for the shortfall in the first quarter. But it will help us get closer to the expectations that we outlined in our year-end conference call in December. So we're pretty much sticking to the guidance we gave at that point in time.

[Operator]

Our next question comes from the line of Alex Stewart, Barclays.

[James Alexander Stewart, Chemicals Analyst]

Just wanted to come back on that guidance point. So you did talk about the consensus, which I think is about 125, and you talked about the guidance you gave at the full year. Can I just be clear that what you're saying is the current consensus you are happy with? Or are those 2 statements independent of each other?

[Richard Armitage, Group Finance Director & Executive Director]

Alex, I think to be clear, we are comfortable with the current consensus.

[Operator]

And our next question comes from the line of Charlie Webb from Morgan Stanley.

[Charles L. Webb, Equity Analyst]

I just want to clarify the first question around the Auto's improvement in January. Is that a natural seasonal sequential improvement we're talking about? Or is that a year-on-year improvement in Autos in January versus 2018 or FY '18? So that's the first question. And just the second one, on the, I guess, some of the moving parts. FX, you've obviously guided to GBP 6 million to GBP 8 million. You're alluding to perhaps it'd be a little bit less than the top end of that. Is there any more sense if we can narrow that down? Is it GBP 6 million headwind? Is it an GBP 8 million headwind? And then likewise, on the SG&A and bonus accrual, again, at the full year, you talked about that being kind of flat year-on-year with some of the investment obviously coming in the first half and less in the second half in terms of investing into the front end. If you could just update on that and how we should be thinking about that first half, second half.

[Jakob O. Sigurdsson, CEO & Executive Director]

So Charlie, on the Auto side, January is not an improvement on January last year. January last year was a very strong one for Auto. However, we do see a return to the momentum that we have had in Auto, mainly driven by sort of unwinding of some issues that were hampering growth tied and driven by WLTP protocols and, obviously, the issue with China and U.S., although that's not abated yet. But I think the point here is that, overall, both in Industrial and Medical, we had a very strong January. On Auto, it didn't exceed January last year, but I think we see a return to, I would say, a reasonable momentum in that area of our business. And we see a continuation of that into February as well as the order book looks like right now. In the FX and SG&A, I'll hand it over to Richard.

[Richard Armitage, Group Finance Director & Executive Director]

So Charlie, so currency is still very much in the range of GBP 6 million to GBP 8 million for currency and inflation and still think about that being a little bit under GBP 5 million for currency and sort of GBP 2.5-ish million for inflation. And we have seen about GBP 4 million of that land in the first quarter. And we expect to see all of that number to land in the first half, if that answers that point. And then SG&A and bonus, so let me deal with bonus first of all, and bear in mind always with our -- most of our bonus accrual is used for the employee bonus scheme as opposed to the executive bonus scheme. We incurred about GBP 14.5 million last year in terms of total bonus accrual. This year, we expect that to be next to nothing. So there is a considerable year-on-year saving from that. And in fact, in half 2, we incurred about GBP 5 million last year. And in half 2 this year, there will be next to nothing. So that accounts for parts of the expected year-on-year improvement in the second half. With regard to SG&A, at the full year results, we did indicate further investment in our technical service and R&D and sales resources in order to keep the momentum of growth in the business. We are not backing off that in terms of the need to do it. We have slowed down slightly, as you would expect in these circumstances, just to manage the P&L a little bit. So rather than sort of GBP 8 million to GBP 9 million kind of number we talked about at the time, think of that in terms of more around the GBP 5 million increase in investment for the year roughly spread over the 2 halves.

[Operator]

And our next question comes from the line of Georgia Harris of Bank of America Merrill Lynch.

[Georgia Emily Mabel Harris, Research Analyst]

Just on the Electronics segment, can you give a bit of color on the growth that you're seeing there, excluding the Consumer Electronics order? So is there any slowdown there from last year?

[Richard Armitage, Group Finance Director & Executive Director]

In Electronics itself, pretty much not. So bear in mind, in our business, we, first of all, look at our Electronics market sector, so that excludes the large Consumer Electronics order and it excludes the sales through our Value Added Resellers. That is very roughly flat year-on-year. And we're reasonably happy with that and that it has not shown a decline. We see further improvement in that sector later on in the year. Then for Consumer Electronics in total, you have to add on, firstly, the Consumer Electronics contract, which, as we have noted, has come to an end. And then secondly, there are a degree of sales through our Value Added Resellers, the work that impacted by some of the destocking that we saw in December. But overall, we are not viewing that as a decline in Consumer Electronics as a sector, if that makes sense.

[Operator]

And our next question comes from Kevin Fogarty of Numis Securities.

[Kevin Christopher Fogarty, Analyst]

Just to clarify one point in terms of the, obviously, Automotive, as you said, are behind last year in terms of January. Presumably, the improvement you're flagging overall in volumes is just a sort of slower rate of contraction, I guess, in January and February. Is that clear? And just secondly, just in relation to Gears, and this is just sort of for my education, I guess, what needs to happen there for that to fall into H2, given the sort of progress you're flagging this morning?

[Jakob O. Sigurdsson, CEO & Executive Director]

I think we are reasonably certain it will happen in Q2. We've done all the advanced protocol work, so that's done in that specific case. This actually represents quite a -- probably the largest gear opportunity that we have had in front of us to date. We're simply waiting for the formal purchase order for that, and that should happen in the next couple of weeks. That will allow us to start producing that in the second half.

[Kevin Christopher Fogarty, Analyst]

Okay. So no further sort of steps in terms of qualifying...

[Jakob O. Sigurdsson, CEO & Executive Director]

No. All sort of testing protocols have been ceded. We've done the prototyping parts, and all the different steps needed to start SOP have been done. We are waiting for the final paperwork to be received for the purchase order.

[Operator]

And our next question comes from the line of Sebastian Bray at Berenberg Bank.

[Sebastian Christian Bray, Analyst]

I would have 2, please. Could I probe your comment on being comfortable with consensus profit before tax expectations a bit more? If I look at consensus volume expectations, which are very in excess of 4,400 tonnes per annum, and then I look at what that implies if you would, let's say, have space -- achieve that over the course of the year, am I right in saying that you'd basically have 3 quarters all close to 1,200 tonnes? From memory, that will be quite strong. That's close to record levels. Is that correct? Or is it the case that you are cutting back a bit, as I think was alluded to earlier, on outcomes spending? I just want to see, are you comfortable with both consensus profit before tax and volumes? Or are you just comfortable with PBT because the spending side will be a bit lower than anticipated this year? That's the first question. And the second is on the development of Value Added Reseller volumes, excluding Auto, how have these been performing during the year so far?

[Richard Armitage, Group Finance Director & Executive Director]

Sebastian, very good point, I think, on the consensus. So it is the latter point that you made that we are reasonably comfortable with the consensus PBT. But the consensus volume is a little high at 4,400 tonnes. You should think more about 4,200 tonnes. And exactly to your point, a couple of things will happen to help us manage PBT. One is slightly lower investments in SG&A, another is the significantly lower bonus accrual, and also a little bit of gross margin improvement in the second half. As you would expect, if we've had a very weak first quarter, our overhead recoveries in the factory have not been particularly good, and that has impacted gross margin. We do expect production rate to pick up and to help our recovery in the second half. So those taken together are what get us to the PBT. And then Value Added Resellers, excluding Auto, I think broadly the way to think about this is we did see an extremely weak December, which points to our customers doing a degree of destocking, and this has happened before. Bear in mind that if we're selling into Value Added Resellers, they in turn are selling stock into their own customers. So when there is a little bit of nervousness about the economic environment, you do tend to see some destocking. We have seen some pickup in the rate of selling in January and also in our forward order book. But the sense here is that what we will see is probably a flat performance year-on-year in the rest of Value Added Resellers business.

[Sebastian Christian Bray, Analyst]

Okay. Just as a quick follow-up. Could I ask, excluding Consumer Electronics and Auto, so I guess you could call this core excluding cyclical one-offs and other, am I right in saying that group volumes were down about 6%, 7% year-on-year?

[Richard Armitage, Group Finance Director & Executive Director]

Very quickly doing some maths, but I think, yes, that's pretty good, maybe 5%.

[Operator]

Our next question comes from the line of Dom Convey of Peel Hunt.

[Dominic Convey, Analyst]

Yes, just a couple of follow-up questions, if I may. I think you were quite explicit about the Auto being 23% down in Q1. And I think it became clearer from the call or clarification that actually Jan, certainly possibly Feb, has seen a reduction in the decline year-on-year rather than necessarily positive. But I just think it would be useful if you could be a little bit explicit what you expect for that second quarter from Auto. And I think just also in terms of those small investments, are you happy at all to quantify the cash outflow associated with those in aggregate? And then finally, at the -- back in December, you gave a little bit of a chat around your preparations for Brexit. I just wonder if there's any update there on either the challenges or those preparations.

[Jakob O. Sigurdsson, CEO & Executive Director]

Dom, on the Auto side, sort of we're more expecting it to turn to a flattish kind of Q2 year-on-year, so not growth. But the dramatic decline that we saw for the world detailed reasons in the first quarter, we're not expecting that to continue, number one. As it relates to Brexit, we are close to having completed most of our supply chain elements of our plan. So in other words, we have stocked up on raw materials here, those that we procure from abroad, number one. Number two is related to outbound shipment. We have increased our inventories both in U.S. and in Asia. And as it relates to our supply chain in Europe, we now have exported almost all of our inventories from the U.K. into a warehouse that's been set up and is now operational in Germany. So as far as all those preparations are concerned, we have completed them. We did install what we call a code red in our Brexit planning in October already. And I think we've been executing in the quarters with that ever since then, and we're now ready for the worst outcome should it go that way, and hopefully, it doesn't.

[Richard Armitage, Group Finance Director & Executive Director]

Dom, so you asked about the cost of the investments. So neither investments required any degree of immediate disclosure. And we will be working on our disclosures in the half year accounts and agreeing those with our partners. So we'll be slightly careful. I think that's a good indicator to hear those. So as with our other technology investments, we will make a progressive investment over time, and that investment is made in line with the achievement of technical milestones by each of those businesses in order to encourage the right sort of progress. And by the end of that program, which is a couple of years out, the investments will not exceed GBP 20 million, to give you an idea of the scale -- sorry, combined.

[Operator]

Our next question comes from the line of Ben Gorman of UBS.

[Ben Gorman, Associate Analyst]

Just 2 very quick ones from me. First of all, on Dental, any update there and sort of any color on patient numbers, et cetera? And then secondly, just in H2, I don't know if you could give a bit more of a scale in terms of the contribution from Gears in revenue expected in H2. Just those 2 from me.

[Jakob O. Sigurdsson, CEO & Executive Director]

So Ben, on Dental, we continue our working relationship, obviously, with Straumann and a couple of other players in the industry. And hopefully, we'll sign up more during the year. We stick to our guidance for Dental this year of reaching meaningful revenue, and that's our target and we would expect to reach that. On Gears, it'll be a relatively small contribution, although Gears should reach meaningful revenues during the year. But I think we're expecting a significant ramp-up related to the program that I referred to in the financial year '20 and '21 and on the back of the other programs that I mentioned.

[Operator]

And our next question comes from the line of Martin Evans from HSBC.

[Martin John Evans, Analyst of Global Chemicals]

Just a quick one. Just again getting back, I guess, to the subjects of guidance and so on, because the press release prima facie really is very cautiously, I think, compared to -- the macro level compared to what you were saying in December about the weak quarter and so on, which is understandable given what a number of your customers have been saying and so on. And then you appear to have these sort of benefits in the second half, which you'd obviously itemized as bonus accrual in the SG&A and so on. If we leave that aside, are what you -- or what are you trying to say here? Are you saying you think you are basically treated worst of what was quite a weak period in your end market and the destocking and so on, or not? Because others are far more cautious than you are, and my slight concern is that you're not giving yourselves enough leeway given the second half starts in only a few weeks. If the sort of macro demand level of the equation things stay where they are or in fact get a little bit worse. So are you sufficiently confident, I guess, that these one-off benefits or the absence of cost from last year will see you through to September?

[Jakob O. Sigurdsson, CEO & Executive Director]

I think good points, Martin. And I think what we're saying is we did see quite a bad first quarter, obviously. We have a certain set of assumptions that are pinned to recovery in the second half, mainly sort of driven by specific projects, but also there's an assumption of some potential underlying recovery in the market in general. I would not say that we are uncautious in our outlook. Quite the contrary, I think we're pointing to a couple of facts that actually tell us that January and February are looking better than we expected. I don't think we're extrapolating too far from these 2 data points, and we would invite you to do so. But I think if we look at, like I said, the outcome for January, which was our second best in history, we look at the order book for February and the signals that we're getting from the market, I think we're cautiously optimistic as it relates to our ability to achieve the guidance that we gave towards the end of last year. And sure enough, there's a lot of moving parts in the world these days and a lot of uncertainties everywhere, so you've got to be careful how you approach market and expectations these days for sure. But I think we're quite transparent about the key assumptions behind the guidance that we have given.

[Operator]

And our next question comes from the line of Alex Stewart[Audio Gap]